Regulatory overkill

This is a good, very fair-minded take on the current financial turmoil and all the more impressive for its insights precisely because the writer is not some sort of ultra-free market ideologue:

“The real roots of the crisis lie in a flawed response to China. Starting in the 1990s, the flood of cheap products from China kept global inflation low, allowing central banks to operate relatively loose monetary policies. But the flip side of China’s export surplus was that China had a capital surplus, too. Chinese savings sloshed into asset markets ’round the world, driving up the price of everything from Florida condos to Latin American stocks.”

Absolutely. China, and the massive pool of savings that Asian economies have been able to provide to Western borrowers, is the 800 pound gorilla in the room in the current saga.

The author continues:

“That gave central bankers a choice: Should they carry on targeting regular consumer inflation, which Chinese exports had pushed down, or should they restrain asset inflation, which Chinese savings had pushed upward? Alan Greenspan’s Fed chose to stand aside as asset prices rose; it preferred to deal with bubbles after they popped by cutting interest rates rather than by preventing those bubbles from inflating. After the dot-com bubble, this clean-up-later policy worked fine. With the real estate bubble, it has proved disastrous.”

Yep, Mr Greenspan has a lot to explain.

“So the first cause of the crisis lies with the Fed, not with deregulation. If too much money was lent and borrowed, it was because Chinese savings made capital cheap and the Fed was not aggressive enough in hiking interest rates to counteract that. Moreover, the Fed’s track record of cutting interest rates to clear up previous bubbles had created a seductive one-way bet. Financial engineers built huge mountains of debt partly because they expected to profit in good times — and then be rescued by the Fed when they got into trouble.”

“Of course, the financiers did create those piles of debt, and they certainly deserve some blame for today’s crisis. But was the financiers’ miscalculation caused by deregulation? Not really.”

Try telling that to the likes of Will Hutton.

“So blaming deregulation for the financial mess is misguided. But it is dangerous, too, because one of the big challenges for the next president will be to defend markets against the inevitable backlash that follows this crisis. Even before finance went haywire, the Doha trade negotiations had collapsed; wage stagnation for middle-class Americans had raised legitimate questions about whom the market system served; and the food-price spike had driven many emerging economies to give up on global agricultural markets as a source of food security. Coming on top of all these challenges, the financial turmoil is bound to intensify skepticism about markets. Framing the mess as the product of deregulation will make the backlash nastier.”

Quite. In recent years, I have often heard fellow libertarians say something on the lines that “we’ve won the economic argument but lost the cultural one” sort of thing. I have never been entirely convinced about that. Yes, old-style central planning and crushingly high tax rates are unlikely to make a comback, but never underestimate the age-old hatred of financiers, of speculators and great wealth. Those of us who might imagine that the big battle of ideas fought after the war against socialism have been won may want to shake off some complacency. But maybe I am being gloomy. After all, much of the current round of government “rescues” are not quite of the same order as the nationalisations of the past. And in some cases, we might hope that eventually states will return banks they have nationalised into private hands.

As the French example of Credit Lyonnais shows – a corrupt bank if ever there was one – state-run banks are just as capable of making a mess of lending as any private one.

27 comments to Regulatory overkill

This bail-out has one purpose: Nulab ‘investment’ in firms and families so that they can continue to issue debt and, in Broon’s plan, act Cnut like and stave off the tsunami of deleveraging.

Once Bear Sterns was rescued, moral hazard ensured that solvency would be tested to destruction, since the taxpayer was lender of last resort. When Lehmann failed, that call was placed in doubt and the death spiral began: now we are faced with an undead financial system that governments can use to ‘invest’.

Who wants to bet that Broon intervenes in bank lending (in the name of ‘fairness’?

I have been looking for a mention of how China contributed to the financial mess, and this article is a good start. But it fails to mention how they amassed their massive pool of American dollars. In order to peg their currency to the dollar to maintain their trade advantage, the Chinese government needed to soak up trillions of excess dollars from the foreign exchange markets. They did this by exchanging the dollars received by their exporters with renmimbi hot off the printing press. It wasn’t inflationary, they reasoned, the new currency was backed by assets. Other countries followed similar policies.

The result was that there was unimaginably huge amounts of American dollars held by ‘sovereign wealth funds’ that had to go somewhere — anywhere. Wall Street happily obliged.

The ultimate result of this meltdown will be a dramatic decrease in the value of the US dollar. The currency-manipulating economies will be the hardest hit by this as their foreign assets shrink, knocking out banks and their obliterating workers’ savings. That’s what happens when you trade real goods for pieces of paper.

It is right to be gloomy. The fact that a good number of supposedly pro-free market commentators (or at least are believed by the press and public to be pro-free market) have been barking for bailouts is absolutely disastrous. These people make it far easier for the left to control the ideological debate.

What Bruce Gottfred said with an additional data point – China started making the transition from Treasurys to ‘real’ assets (stocks, land etc) last spring. If you look at their holdings of Treasurys trending strongly up and then back down, you can pretty well overlay it on that change to stocks, etc. IIUC, prior to that they didn’t have a typical SWF as such.

I suspect that was a big part of the trigger.

As for a single cause, there is one that comes close to that description. When the gov intervened in private contracts by telling banks to lend out money they didn’t have under contract from the depositors (fractional reserve) they interfered with so many market forces that it is quite reasonable to say that everything grew from there. When depositor’s money is under contract that ties the term of the deposits with the term of the loans, bank runs can not happen. They just can’t. Consider fractional reserve lending to be like running naked shorts on deposits – if things get ugly, the deposits can’t be reconciled.

Instead of letting banks agree to and be held to terms with their depositors, the gov commandeered that relationship. When the inevitable happened, the FDIC had to be introduced to offset the intrinsic structural problems. Now we see in a very big way what happens when and savings and lending are detached from each other, from market forces and from accountability.

Of course the reason for doing all of this from the very start had nothing to do with helping free trade and everything to do with expanding government.

There is a name for the gap between the term of the deposits and the term of the debts but it slips my mind at the moment.

A few months ago, there was a post at Samizdata about the possibility that a really big crash might bring about the opportunity to sweep away some of the collectivist deadwood from the economy, and society in general. Several of the commenters favored such a scenario, contending that there would be disenchantment with the state if things got bad enough.

Well, this may or may not be that crash that we were speculating about, and, as I unhappily predicted, it is not the state, but the lack of enough of it that has been immediately cited as the cause of the problem by most all of the formulators of the “conventional wisdom”.

A very short history lesson. In 1911, there was what was then called a “bank panic”. In response, the new progressive political forces then on the upswing in our society proposed that the state more closely monitor the banking system.

Thus was born, a few years later, the Federal Reserve System. Bank panics, the progressives solemnly promised, were now a thing of the past.

In the early to middle 1920’s, banks in the west and midwest began to fail for a variety of reasons. Finally, in 1929, the snowball reached Wall Street, and the Market crashed.

The Fed promptly tightened up credit and the money supply, which is now widely acknowledged as exactly the wrong thing to do, and the economy went into a tailspin.

Fast forward to the 1990’s. The state, for various political and social reasons, but not economic ones, massively supports and encourages loans to persons who would normally be denied under the standard rules of credit traditionally used to evaluate loan applications.

Two major state entities, Fannie Mae and Fannie Mac, underwrite and subsidize these loans. A feeding frenzy occurs, and a speculative bubble forms which vastly inflates real estate and other values, especially the value of these very sub-prime loans.

The bubble bursts.

What is the response?

It is solemnly declared that the problem was not enough regulation, too much freedom for greedy speculators, and the remedy is for the state to buy up and take over major segments of the fnance and credit system around the country and around the world.

Those of you who wanted a crash, you got what you wanted, in spades. Happy?

VR, this isn’t the crash. This is a control system failure at altitude. I imagine the pilots will try a lot of things before we ‘contact terrain’. ‘The crash’ when/if comes, will arrive with the failure and abandonment of either the dollar or deficit spending. At that point, government as we now know it will cease to exist. Whether that will resolve better or worse, I don’t know.

The Fed/Government has two choices. One is to protect the dollar as they did in the Great Depression. That would starve handout programs. The other is to monitize. That will destroy the dollar. Either course has substantial consequences to redistributive payments. They appear to be monitizing.

“The fact that a good number of supposedly pro-free market commentators (or at least are believed by the press and public to be pro-free market) have been barking for bailouts is absolutely disastrous.”

The root cause of this problem lies in the government interference in free markets. Namely, it was the expansion of the Community Reinvestment Act in 1994 along with the easing of credit standards at Fannie and Freddie to accommodate CRA objectives.

In addition, there was complicity. The investment context was a high valuation, low yield world. The Fed kept interest rates to low for too long and Greenspan had injected massive amounts of fiat money whenever there was a crisis. Attempts at reforming the GSEs were blocked at every turn by Democrats. Wall Street, which allocates capital, figured out how to create securities to distribute. International banks also got in the game. Ratings agencies added investment grade ratings. Hedge funds used leverage provided by banks to juice returns, increasing demand.

Now governments are intervening on a global and massive scale taking us farther down the road of socialism.

The trade imbalance with the Chinese did impact demand and prices for US Treasuries. However, I do not think that China’s foreign currency reserves caused this crisis.

Furthermore, there was little deregulation in financial markets. No one believes that Glass-Steagall would have prevented the subprime mortgage crisis.

Veryretired is correct: financial panic will not lead to more freedom, but less; not to less government intrusion, but more. Witness post-World War I Germany.

I agree with much of what Barrett said, but I think he (and others) overstate the impact of the CRA on this whole mess. Yes, it was (and is) a stupid law, but most banks treated it largely as a marketing expense and never really expected stellar returns on those loans. (Also, they received CRA “credit” for various other activities, too, such as making inner-city commercial loans, contributing to community organizations, etc.) In addition, (before last year’s industry implosion) a large percentage of residential mortgage loans were made by independent mortgage companies, which are not subject to the CRA (it only applies to banks and their affiliates).

I have cataloged in other posts the panoply of entities sharing responsibility for the current situation, but I think a substantial amount of the blame belongs with FNMA and (slightly less) FHLMC. They saw the large (in percentage terms) profits being made on subprime lending (back in the days when it was being intelligently done; that’s another long post if anyone is interested), muscled their way into that market, and ultimately destroyed it because they completely failed to understand (or price for) the risks. They continually ratcheted down their FICO score requirements, modified their automated underwriting “black boxes” until eventually almost everyone qualified, and ultimately turbocharged and completely transformed what had once been a rather sleepy (but profitable) cottage industry.

Subprime lending is an art, which requires a deep understanding of borrower psychology (old-line subprime lenders were highly suspicious of simplistic FICO scores, and with good reaon). Conforming lending is a statistical exercise, lending itself well to mass-production techniques. That’s why, historically, companies did one or the other; no underwriter could be expected to handle both types of loan. The Agencies tried to turn it into a science, with predictable results.

Well, I am a free market ideologue and there is nothing wrong with that. I don’t rake in money like other idelogues since my beliefs mostly benefits others. I’m not a televangalist who preaches god and lives in a mansion, nor do I pull in a big salary like many heads of non-profits.

I’ve been pointing out for a long time that the opening up of not just China but all those other socialist countries under the Bush/Thacher revolution was deflationary and was fooling Alan Greenspan.

Instead of believing good economics, Austrian economics, which says that we shouldn’t interfere with market prices to maintain “price stability” Alan Greenspan followed monetarist policy. He ignored all the signs that what he was doing was wrong. That in fact he was inflating the money supply.

Those signs were the known results of monetary inflation according to Austrian theory. When you hold interest rates below the market you are of course going to get producers producing less and consumers consuming more.

To list a few of the known symptoms of holding interest rates low according to the theory:
1) Low Savings
2) Trade Deficit
3) Asset inflation
4) Stock mania
5) Increased invesment in long term goods = Housing mania
6) Increased borrowing
7) Increases in commodity prices followed by consumer inflation.

These sound familiar.

Also don’t forget that the Bureau of Labor Statistics had be fudging inflation numbers during this whole period thereby underestimating inflation. So Alan Greenspan wasn’t even really targeting price stability.
Like the driver of a car with a faulty speedometer that gives too low a reading he was speeding without even realizing it.

Unfortunately the inflation rate is a measure of acceleration, and not speed. At least the driver of a car will slow down once he reaches his target speed. If you are in a plane with a faulty accelerometer that reads 9.8 meters a second off you will soon find yourself falling at the rate of gravity towards the earth with your speed constantly increasing.

“The Fed promptly tightened up credit and the money supply, which is now widely acknowledged as exactly the wrong thing to do, and the economy went into a tailspin.”

Tightening credit was not exactly the wrong thing to do. In fact it was the right thing to do and should have been done much sooner. The best thing to do would have been to let the market decide a market price for credit.

Also you have the facts wrong. The first thing the Fed did was to loosen credit. Lots of cash was injected into the system via many programs by Hoover. It didn’t help, and if you read to the end of my comment you will see why.

What was the wrong thing to do and what caused the problems was setting price floors during the deflation. If you tighten credit lowering he money supply then you need to let prices fall. The unemployment was caused by price floors in wages, the problems with farming were caused by price floors on agricultural goods, etc.

This is THE ONE FALLACY of the day that is going to cause politicians to take the wrong action. It will cause them to lower interest rates and dump money into the system to prevent the market from correcting.

However, low interest rates and dumping money into the system are precisely the actions that caused the problem in the first place.

During the 1970s we had gas lines precisely because there was a price cap on gas and oil. Producers in the south saw no profit in shipping petroleum to the northeast during the winter. They couldn’t get any more than if they just sold locally, or overseas.

Buyers lined up to get as much gas as they could and at the low prices were willing to waste that gas once they got it. They had plenty of money to buy gas at those prices and did so. They were only restricted by the quantity that was delivered and thus spend time on long lines waiting for the opportunity to buy.

In short price controls cause shortages.

The correct solution to the problem of gas lines and shortages is to let prices rise. The answer is to remove the price controls. The answer is NOT to lower the price ceiling on gas, as that will only cause addition problems.

Interest rates are just another price, and the targeted Fed rate is precisely a price control system. There is a difference in the good being priced however. Interest rates are the time cost of money and that effects prices on all goods throughout the system. It does not however do so evenly or immediately. There is a time delay.

There are other differences. Money serves the purpose of an exchange medium and it is important that the quantity is stable for it to serve this purpose. We are on a fiat system and therefore the quantity of money is highly dependent on what the Feds do.

All price ceilings cause lines of some sort or another. Be it waiting on line at the gas station, or rationing via coupons. Lines form.

Due to the above mentioned differences of the good called “a loan” one can get a delayed shortage line when messing with interest rates. That is exactly what we are seeing now.

Think of the difficulty that people are having in getting loans now as the same phenomenon as waiting on the gas line for a good that is underpriced.

The Fed lowering interest rates is going to have little effect on the lines for the same reason that lowering the price ceiling on gas would not have an effect on lines at the gas station.

There is a difference. The producers of gas can’t produce more gas, but under a fiat system the government can produce more money.

Unfortantely it’s a mistake to believe the extra money will fix the problem and free up the lines. The problem is that the lines really aren’t about getting currency. They are about borrowing capital.

Savers, under a monetary system with a stable quantity of money, are actually saving capital into the system. The only way you can save a thousand dollars is to produce one thousand dollars more of goods than you consume. Those goods are out in the system and then when you lend someone your cash they can buy those goods.

The line to borrow is about borrowing those goods. It is not about borrowing the currency, the medium of exchange for those goods. In the gas analogy it’s as if the governments response to the shortage were to be to hand out even more cash for people to buy gas.

That might at first trick the producers and cause them to produce more, but only because they can use that extra cash first to purchase the inputs they need to profitably make the gasoline. It will divert other resources in the economy towards production of gas. Eventually everyone is going to catch on to that scam as prices rise in general.

Unfortunately, we are not talking a single good here. We are talking about a low savings rate in general. There is a general lack of capital in our economy and therefore nowhere to shift capital from using these newly minted claims on capital, the cash.

The end result will be inflation, or even Zimbabwean hyperinflation if repeated over and over.

People want to borrow but there is not enough capital in the system to borrow. Every businessman is trying to hold onto the capital he has and is not going to be willing to lend it to anyone else. What needs to happen is that those businesses that are least productive need to go out of business and free up their capital to other businessmen.

One of the effects of low interest rates is to distort the market towards businesses that produce goods that are far away from consumption. Long term businesses (like housing production) get too much of the saved capital during the boom. This capital needs to be freed up. That can only happen with falling prices and rising interest rates.

Unfortunately once savings are converted into some forms of captial it’s a dead loss. We will not be able to convert houses back into anything useful. So the correct thing to do is still going to hurt. There is absolutely no path out of this crisis that won’t look bad.

The path we have chosen however will make things worse. Lowering interest rates and keeping prices high is going to distort the market further and not allow capital to flow to the most productive activities that the consumers want at this point.

We do not need any more houses built at this point, we do not need any more internet companies. What we will need is production of short term goods like food, gas, etc.

Get ready for the inflation because no one believes this. Not even many who claim to be for free markets.

Equality of result is something our leftist/socialist political classes have advocated and pushed-for for some time. Here in the states, the CRA is a case in point. It appears we are finally headed in that direction at breakneck speed. We all may soon be as broke and without options as the poorest welfare recipient. Welcome to the new “fairness”.

From the leftist POV, the CRA (and other like initiatives) was a brilliant plan. If it worked they got a degree of “fairness”. If it didn’t work, they got the “fairness” we’re headed for now.

If this debacle (whatever its ‘root’ cause) was not contrived and orchestrated by the left, they must surely be upset for not thinking of it sooner and implementing it themselves.

Rather than looking backward, the question now should be, what new disaster will be foisted off on us as the solution to the current mess? A single world currency? A world government? Abandonment of private property rights? The mind boggles at the many opportunities now opening for leftist mischief.

This is a very insightful remark. It recognizes that capitalism requires a moral defense, not merely an economic one. Of course, Ayn Rand realized this decades ago, and the folks at ARI (aynrand.org) continue to drive home this point to any libertarian and conservative would-be defenders of capitalism who will listen.

Laird (or others): in the theoretical absence of any government interference, except for continuous low interest rates like we have seen for the last several years, wouldn’t some kind of bubble be inevitably formed, and later burst, as bubbles are bound to do? What I am saying is that my gut tells me that regulation is the relatively minor culprit in this case, and the main one is the funny money. (Unless one regards government fiat money as the most basic form of regulation, that is. That is not what the MSM talking heads mean when they talk about regulation though, so I conform to the accepted semantic). What am I missing?

Laird,
I’d be interested in how you define “intelligently done” as applied to subprime lending.

The only thing I can think of is either LTV <80% or interest rates sufficiently high that, if you take a bunch of subprime loans together and subtract the defaults you’re still getting the same return as you would from loaning the money to people who pay you back.

Alisa,
I’d say that the regulation involved is non-trivial. CRA-mandated loans to the non-creditworthy to avoid getting calls from ACORN lawyers might be a small percentage. However, the people who took those loans bought houses, which increased demand, which fueled the price increases that led bankers and real estate agents to tell other people that prices would continue to climb.

Meaning: subtract any one of these factors and the situation wouldn’t be nearly so bad IMHO. They fed off each other. Idiot debtors, idiot creditors, real estate people, etc. are behaving like a psychological crowd and the ordinary rules of logic applied to human behavior[1] don’t apply, but there is a logic to this crowd behavior.

(So that anybody who insists that there are only individuals, and that there’s no difference in behavior just because there are a few dozen of them interacting: you’re full of it. They may have the same moral responsibility for their actions as they did as individuals, but the behavior is very different.)

[1] Someone is saying “I never thought I’d ever hear a cop say that human behavior is logical.” What I’d learned in school was that you can change the conclusions that people reach through strict logic, by changing the premises they start with. Which is what I think Perry and others mean when they talk about “building the…metacontext.” The difference being that he, and I, and most others here are trying to shift the premises back to something to accurately describes the world as it actually is.

Sunfish, trivial is certainly not the word I would use – I chose ‘relatively minor’, I think, while fully understanding all the factors you have listed.

subtract any one of these factors and the situation wouldn’t be nearly so bad IMHO.

This is my main point, and this is what I doubt, although I could certainly be wrong. When you pour money into the system, it has to go somewhere. My background is in physics, so I think of it as of connected vessels rule. And, of course, I agree with you on the herd behavior, but I think it is beside the point, as it is part of human nature, and as such has to be treated as a given in any market.

Maybe not in the shorter term. I think it would have taken the bubble longer (maybe much longer) to form, but it would have been much larger. Fewer people would have noticed anything along the way, and the inevitable explosion would have been much more powerful and disastrous.

With the creation of central banks, currency underwent several significant changes. During both the coinage and credit money eras the number of entities which had the ability to coin or print money was quite large. One could, literally, have “a license to print money”; many nobles had the right of coinage. Royal colonial companies, such as the Massachusetts Bay Company or the British East India Company could issue notes of credit—money backed by the promise to pay later, or exchangeable for payments owed to the company itself. This led to continual instability of the value of money. The exposure of coins to debasement and shaving, however, presented the same problem in another form: with each pair of hands a coin passed through, its value grew less.

The solution which evolved beginning in the late 18th century and through the 19th century was the creation of a central monetary authority which had a virtual monopoly on issuing currency, and whose notes had to be accepted for “all debts public and private”.

I wonder how much the part that I emphasized in bold was really a problem, and if it was, what solutions could have been applied other than monopoly by the state.

I think I agree with Alisa on this one. Once the Fed turns on the money pump, the balloon called ‘investment’ starts expanding. At that point all market regulation amounts to is trying to squeeze the balloon. If it hadn’t been sub-prime loans, it would have been sub-prime tech stocks. Or sub-prime . . . ? It is not entirely a coincidence that the rupture forms where government involvement is the highest, but even in the absence of all non money-supply interventions, it would have to rupture somewhere.

So in a way, you’re both right. It is like playing reverse musical chairs. Instead of removing chairs from the game, the Fed kept adding players (dollars). When the music stops, there aren’t enough ‘ass sets’ (err, chairs) for all the asses. This isn’t really a lending issue so much as an investment issue.

I won’t get into it here, but the money multiplier effect is how Fed policy controls money supply. The actual contribution of the national debt to money supply is secondary. Manipulating interest manipulates lending manipulates money supply. The size of the fraction in ‘fractional reserve’ controls how finely the Fed can control money supply (bigger fraction = more control) but at the cost of limiting the extent of effect possible. Believe it or not, at 10%, the US is conservative compared to Yurp.

OT, I woke up to shotgun cannonades this morning. I guess it’s goose season.

I should have said “at the cost of limiting the extent of manipulation possible.”

Given a choice between behaving responsibly or having power, pols always chose more power. At 100% fractional reserve they would have total stability but no power. The power would then be entirely in the hands of the depositors. Which is where it should have been all along.

Now if we take the other extreme scenario, and say that there is all this government interference, Fanny and Freddie and the rest of it, but the Fed’s policy has been responsible throughout, and all the money in the market corresponds to actual savings, goods produced etc, and there is a constitutional provision for keeping things that way. What would have happened then? My intuitive answer is that the government wouldn’t even have thought about coming up with all this “home ownership for all” nonsense. Am I wrong?

While the crash of Freddie and Fannie and the lack of real government controls on them was the catalyst for this meltdown, how could it become such an overall bleed out without someone or something spurring on the bears? You cannot totally ignore the political implications of a failing economy. In such a situation, the party in the White House loses. Yet although the markets in the UK, US and others stopped short selling, very few people seem ready to consider that we may have seen an example of what can be done to a fragile economy when it is leveraged by outsiders for political goals. Put someone like Soros-who knows how to manipulate markets-or any of a group of largely leftist socialists that just happn to have attained great wealth, mix them with new money from commodity rich Third World movers and you have a defacto economic army ready to do battle.

Mark my words, money like water, has to go somewhere. If the day after the election, the Stock Market soars to 14000 in support of the “new order” then you will know that this election has been bought and paid for. And that we Americans are the losers.

Who Are We?

The Samizdata people are a bunch of sinister and heavily armed globalist illuminati who seek to infect the entire world with the values of personal liberty and several property. Amongst our many crimes is a sense of humour and the intermittent use of British spelling.